A Superior Idea for a Common Problem

A few companies are trying to get the government to convert its preferred shares to common ones, but Superior Bancorp in Birmingham, Ala., had an even better idea, one widely expected to inspire imitators.

This week the $3.2 billion-asset company exchanged $69 million of preferred shares it had issued to the Treasury Department for the same amount of trust-preferred securities.

In doing so, Superior managed to raise its tangible common equity ratio without diluting shareholders.

The government also benefited by getting an even safer investment, since it now holds debt instead of equity.

Jim White, Superior's chief financial officer, said the exchange is a rare instance of mark-to-market accounting working in favor of the banking industry.

The company received a $22.5 million gain from the exchange, because the newly issued trust-preferreds, with a 5% coupon, pay less than the going market rate for similar securities.

"In my 37-year career, it's about time that one came out in our favor," White said. "I think it is a very attractive transaction for an institution that is seeking to increase their tangible common equity ratio."

Superior is believed to be the first community banking company to make such an exchange with the Treasury.

In February the Treasury agreed to restructure its investment in Citigroup Inc. to increase the company's tangible common equity ratio, including exchanging $20 billion of preferred shares for trust-preferred securities. But that exchange, which happened this summer, was generally viewed as a special case for a company that had received extraordinary government assistance under the Troubled Asset Relief Program.

It was the $35 billion-asset Popular Inc. in San Juan, Puerto Rico, that really caught the industry's attention.

In August Popular converted its $935 million Treasury investment, a maneuver that allowed it to add $500 million of common equity.

Analysts said many in the industry didn't realize a trust-preferred exchange was an option until Popular completed its deal. More are expected to pursue the idea now that the Superior exchange has confirmed the Treasury is receptive.

KBW Inc.'s Keefe, Bruyette & Woods Inc. suggested the exchange to Superior; the company submitted its offer to the Treasury on Oct. 23 and heard back Oct. 30, White said.

"I was stunned at how quickly they responded," he said.

Industry watchers said a trust-preferred exchange is a better deal than a common stock exchange for both the Treasury and the company. The Treasury's investment, which changes from an equity position to a debt position, will have a higher place in the pecking order of repayment. And Superior's shareholders will not be diluted as they would with common stock.

"I don't see any problems with it," said James Schutz, an analyst at Sterne Agee & Leach Inc. "The earnings implications are exactly equivalent. They have interest expense rather than a preferred dividend."

The trust-preferred securities pay 5% annually, and switch to 9% annually in 2014, exactly as the preferred shares did.

But while most trust-preferred securities have a tax-deductible dividend, Superior will continue to pay taxes as if it had preferred shares, White said.

For bank holding companies, trust-preferred securities are typically allowed to make up only 25% of Tier 1 regulatory capital. But because Superior is a thrift holding company, the 25% cap does not apply, White said.

To be sure, the capital boost at Superior is an accounting gain, not a true capital raise.

"It's a bit of smoke and mirrors," said Kevin Fitzsimmons, a managing director at Sandler O'Neill & Partners LP. "It modestly bumps up tangible common equity, which was the motivation. I view it as kind of neutral to net positive. It is a little bit of financial engineering, as opposed to adding some capital."

But the boost still improves the perception of Superior among investors, who consider a company's tangible common equity ratio an important measure of its health, analysts said. Generally this ratio is considered worrisome when it falls below 5%.

The boost also could help Superior get a better reception when doing a capital raise, as it is expected to do.

Fitzsimmons said more companies likely will look into such a conversion because of the benefits. "I would suspect there will be more because there are a lot more companies out there in Superior's position," he said. "It was a way to manufacture a gain and optically build the capital position, and if the Treasury seems open to it, then why not do it? It is more positive than doing a common raise for the same amount because it is not dilutive."

Rob Klingler, an associate in the Atlanta office of the law firm Bryan Cave LLP, said his firm is already hearing from companies that are interested in such an exchange. "It makes a lot of sense," he said.

Still, the exchange would not work for all companies, Klingler said. Banks without holding companies cannot issue trust-preferred securities. It also may not work for those restricted by the Federal Reserve from incurring additional debt. And the benefit of an exchange may be limited for bank holding companies that have already issued a large amount of trust-preferreds, because of the 25% cap on counting such securities as Tier 1 capital.

Superior has laid the groundwork to sell stock. On Nov. 19 the company received approval from shareholders to increase its share count from 20 million to 200 million.

Fitzsimmons said he would like to see the tangible common equity ratio rise to 7% or 8%.

In a note to investors, he wrote, "We don't believe that the benefit from the exchange is significant enough to preclude a potentially very dilutive capital raise."

Like many in the Southeast, Superior has had trouble with its residential construction and land development loans lately. In the third quarter Superior had a net loss available to common shareholders of $287,000.

Its provision for loan losses more than doubled, to $5.1 million, as nonperforming assets climbed to 6.06% of total assets.

The results included a $17 million writedown on its investments, including private-label mortgage-backed securities and, ironically, trust-preferred securities.